Two complementary ways of creating money

Economic growth requires a concomitant increase in the money supply. Without such an increase growth will be constrained because consumers and investors won't have the money required to increase demand through investment and consumption. While in theory economic activity can increase without expansion of the money supply if prices and wages decrease, i.e. if there is deflation, deflation depresses economic growth because it provides a powerful incentive to save money instead of borrowing or spending it.

There are two distinct and complimentary methods of money creation in modern financial systems. These first is private credit creation by bank lending. The second is deficit spending by governments. I will argue in this article that both methods are needed to allow sustainable economic growth, and that the global financial crisis was the result of excessive reliance bank lending because of misconceived opposition to deficit spending.

Private credit creation. It is not widely appreciated that banks are able to create money at will by making loans. They simply credit the bank account of the recipient. They have no obligation to raise or borrow that money in the first place. Of course, as this is a loan with an associated debt, this process does not create net new money; loans and debt always cancel each other out. The factors restricting money creation by banks through loan creation are capital requirements and the commercial decision as to whether the loan will be profitable. There is a notion that the central bank controls bank lending by requiring banks to hold some of their money as reserves at the central bank. However banks can in practice always borrow whatever reserves they need at the prevailing base rate, so reserve requirements are not a real restraint on lending.

The second mechanism of money creation is deficit spending. This mechanism of money creation is only available to governments that issue their own currency - which includes most countries. If more money is spent (created) than taxed (destroyed) then net money is created. Crucially, this money is not balanced by a loan. It is debt-free money. Deficit spending is the only way that net financial assets can be added to the banking system. By adding net financial assets deficit spending allows the private sector to increase its savings (or reduce its debts). Conversely a government budget surplus requires the private sector to reduce its savings (or increase its debts).

There is a widely held belief that deficit spending crowds out private investment because it requires that the government borrow money to fund the deficit in competition with the private sector. This is only true for governments that dont issue their own currency. There is a crucial difference between deficit spending by a currency-issuing versus currency-using governments (e.g. any Eurozone government).

A currency-using government has to borrow money BEFORE it can spend it, just like the rest of us. It is therefore competing with other borrowers for funds. This applies, for example, to Eurozone governments.

In contrast, currency-issuing governments borrow money AFTER they have spent it. They create money when spending, which flows into the banking system, creating extra reserves. Governments then usually 'remove' this extra money from the banking system by selling bonds of an amount almost exactly equal to the budget deficit. This is done for two reasons. Firstly, in most countries it is a formal, but entirely self-imposed, requirement that the government does this, supposedly to 'fund its budget deficit' or at least give the appearance that it is doing so. However this 'borrowing' can only happen AFTER the money has been added to the banking system by government spending. So clearly the government is not 'competing' for these funds with the private sector - it is simply providing a safe place for the private sector to store the extra funds that they received from the government through deficit spending.

The second reason that goverments sell bonds is to enable central banks to target interbank interest rates to a specific level. If there are excess reserves as a result of deficit spending banks will be unable to earn any interest on by lending these funds and the interbank interest rate will rapidly drop to zero. Since central banks are required to meet a specific interest rate target it is necessary for the government to 'drain' the excess reserves created by the deficit spending, and they do this by selling bonds. What this does is transfer bank reserves to the equivalent of a savings accounts. So currency-issuing governments 'borrow' the money after they had spent it. They are not really borrowing it to fund spending. Instead, they are keeping it in a savings account on behalf of the private sector. Government debt or the national debt is really just private savings. High levels of debt represent high levels of private savings. Conversely, paying off the national debt by running budget surpluses means reducing these private savings!

The neoliberal consensus that has prevailed for the past 3-4 decades has held that money creation by banks is good whereas money creation by deficit spendings is to be avoided. The basic argument, which is based on microeconomic theory, is that by coupling it with a debt obligation money creation is disciplined by commercial considerations. The fact that interest will need to be paid and the debt will eventually need to be repaid ensure that money is only created to fund a viable economic activity. Hence money creation is less likely to be excessive and therefore inflationary. In contrast deficit spending lacks the same discipline and is thus more likely to be excessive and inflationary.

Hence the neoliberal approach has been to aim to avoid budget deficits and balance the budget over the business cycle. Since deficit spending is one of two methods of money creation, avoiding deficit spending requires that governments rely exclusively on bank lending to meet demand for money. I would argue that this is profoundly mistaken, and indeed is the underlying cause of the global financial crisis. Unless this policy is changed sustainable growth cannot be restored.

The reason why it is flawed is that it requires an increase in bank lending (and private debt) without a concomitant increase in net financial assets. What this means is that as the economy grows the overall or aggregate ratio of debt to capital (i.e. the leverage) has to increase relentlessly. It can only stabilize or drop if private lending stops. However since, in the absence of deficit spending by governments, economic growth absolutely depends on private credit expansion, there is a powerful incentive to allow ever higher levels of bank lending and private debt. [I should add here for completeness that it is possible to grow without budget deficits or increased private borrowing through increases in net exports. However this simply shifts the borrowing to the private sector in importing countries. This aggravates the problem in other countries and is not sustainable in the long term.]

The need for ever increasing private sector borrowing to fuel growth was met by the relentless deregulation of banks and financial markets over the past 30 years. More recent support has come from central banks lowering interest rates to record low levels.

Unfortunately this private lending and the policies that support it can predispose to asset price inflation and asset bubbles. When money is so cheap it is tempting to borrow money to purchase assets (e.g. houses, stocks etc) that are increasing in value. Banks are also generally happy to lend money to purchase assets that are rising in price. This is self-perpetuating since more borrowing leads to further price increases which encourage further borrowing. Inevitably this results in credit bubbles as private debt reaches an unsustainable level before the bubble pops. That is what precipitated the global financial crisis. When asset bubbles pop bank lending will wind down as the private sector tries to reduce their debts. This deleveraging process is also inherently unstable because as people try to pay off their debts they reduce consumption and sell assets which decreases prices further and therefore aggravates the debt problem. This forces central banks to intervene to stop this process. They do this by lending freely to the banking sector at very low or zero interest rate. This can prevent collapse but it will, on its own, not stimulate growth until the private sector reverts to borrowing again, and this only likely when debt levels (and thus the money supply) have dropped substantially, creating much damage in the process. This will include immense human misery, destruction of wealth, deteriorating public goods such infrastructure and education, and a permanent reduction in the productive capacity of the economy, damaging the well being of future generations.

Growth may then restart from a low base but, as before, it will be constrained by the fact that balanced government budgets mean that no net new money (i.e. capital) is being made available, so economic growth requires increasing leverage and deregulation of lending practises. Eventually this will reach its leverage limit and the economy will shrink again. This cycle could take 30-40 years.

The way to avoid this cycle is to move away from relying exclusively on credit creation and instead use a combination of credit creation and deficit spending to grow the money supply. Because deficit spending adds net financial assets to the banking system it allow growth in bank lending without increased leverage.

In my next post I will discuss why deficit spending is particularly critical now as our economies struggle with the aftermath of the global credit crunch and why fears that deficit spending will bankrupt governments are misplaced.